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Debt to Income Ratio: Importance and How It Is Calculated

debt to income ratio

Besides credit score, debt-to-income ratio is another important factor in determining your overall financial condition. Calculating the DTI ratio helps determine how comfortably you manage your current debt and decide if applying for more credit is the right thing to do. When you apply for a new loan like a debt consolidation loan, lending institutions calculate your DTI ratio to determine your lending risk and repayment capacity. In the following sections, you will understand the DTI ratio, why it is important, and how to calculate it.

What Is a Debt-To-Income Ratio?

The debt-to-income ratio is a numeric value in percentage, measuring your debt repayment capacity in relation to your gross monthly income. Simply put, it is the total of your monthly obligations divided by your gross monthly income. Financial institutions use this ratio as a tool to anticipate your ability to pay monthly EMIs towards a new loan you seek. A high DTI ratio indicates low repayment capacity and vice versa. Ideally, your DTI ratio should be at most 40% when you apply for a new loan.

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Why Is Debt-To-Income Ratio Important?

The debt-to-income ratio impacts various areas of your finances, determining your loan eligibility. A high DTI ratio lowers your eligibility for new credit facilities because lenders foresee a low repayment capacity due to high debt levels. Conversely, you can easily get more credit if your DTI ratio is low. The DTI ratio also determines your credit limit. If your current income is sufficient to repay higher debt amounts, you may be eligible to borrow higher amounts. While you may need external funding to study abroad, build a dream home, or buy a new car, a low DTI ratio will enhance your loan eligibility and affect your financial goals.

What Are the Limitations of the Debt-To-Income Ratio?

Although crucial, the debt-to-income ratio has some limitations as well. Let’s discuss them.

  • DTI ratio is only one factor that lenders use to make their credit decision. They have several other parameters based on which they determine your eligibility, loan amount, interest rates, repayment terms, etc.

  • The calculation does not distinguish different debt types and their servicing cost. For instance, your credit card might have a higher interest rate than your debt consolidation loan. However, you will lump together both while calculating the DTI ratio. If you take a low-interest loan to pay off the balance, your monthly payments will decrease, but the total outstanding amount will remain unchanged.

How to Calculate Debt-To-Income Ratio

Follow these steps or use an online debt-to-income ratio calculator to calculate your DTI ratio and make an informed decision regarding taking a new loan:

Add Up Your Minimum Monthly Payments Divide Your Monthly Payments By Your Gross Monthly Income Convert The Result To A Percentage

Add up all your monthly financial obligations, including monthly rent or house EMI, children’s education fees, student or auto loan EMIs, minimum payment on credit card bills, insurance premiums, etc.

Divide the total of your monthly bills by the gross monthly income you receive before taxes. If you use an online DTI calculator, enter your annual income and total monthly payments to calculate your DTI ratio within a flash second.

The result you get is the DTI in percentage form. The lower this number is, the less risky you are to a prospective lender. Ideally, a DTI ratio below 40% indicates that you are comfortable with your debt payments and take some more.

How to Lower a Debt-To-Income Ratio

If you have a high debt-to-income ratio, try reducing it to convince loan companies of your ability to take more financial obligations. Here’s what goes into reducing the DTI ratio to improve your position as a borrower:

Pay Off Your Smallest Debts Raise Your Income Put Another Person On The Loan Use A Co-Signer

Paying off large debts with high loan amounts and high interest rates may take time and considerable finances. However, target your smallest debts to clear the mess. After repaying the smallest debts, you can focus on the larger ones and direct your finances towards them.

Apart from reducing your outstanding balances, raising your income is one way to lower the DTI ratio. As your income increases, you get more money to pay your current debts, thus reducing your debt-to-income ratio. Find additional ways to earn money, including rent, part-time jobs, freelance work, making from hobbies, etc.

Adding another person on the loan will combine both incomes. The strategy will make the lender feel safe lending to you due to the higher chances of loan repayment. When they have two accountable people to repay the loan, they may agree to approve the loan application.

Use a co-signer with a high income, decent credit score, and low DTI ratio to make the lender feel confident in lending. When a reliable co-signer takes the guarantee of your loan repayment, the chances of getting approval increase significantly.

Conclusion

While looking for a loan, you must do everything possible to keep your debt-to-income ratio low. It shows potential lenders that you have a good relationship with credit and know how to manage it well. It also indicates that you have a monetary cushion between your income and financial obligations to absorb any unforeseen expenses. Use an online DTI calculator to calculate this number and see how prospective loan companies perceive you. A Personal Loan EMI calculator online will calculate EMIs for a new loan, helping you make an informed borrowing decision according to your repayment capacity.

Frequently Asked Questions

1. Is 50% a Good Debt-To-Income Ratio?

A DTI ratio of 50% is not favourable for your loan application. Prospective lenders may see you struggling to meet your existing debt obligations. As a result, they may reject your loan application or offer a smaller loan amount at higher interest rates.

2. Is a 20% Debt-To-Income Ratio Bad?

A DTI ratio of 20% indicates that you have enough monthly income to pay off your obligations and put towards savings and investments. Most loan providers will feel safe lending to you with an assurance of timely monthly payments.

3. What Is a Bad Debt Ratio?

A DTI ratio above 50% is a bad debt ratio that reduces your eligibility for more loans. A high debt ratio may also stretch your finances and make repayments challenging for you. So, try to increase your income or reduce your obligations to reduce your debt-to-income ratio.


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Did You Know

Disbursement

The act of paying out money for any kind of transaction is known as disbursement. From a lending perspective this usual implies the transfer of the loan amount to the borrower. It may cover paying to operate a business, dividend payments, cash outflow etc. So if disbursements are more than revenues, then cash flow of an entity is negative, and may indicate possible insolvency.

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